LONDON (Reuters) — As the tidal wave of
global central bank liquidity recedes in 2014, emerging market
investors are growing more anxious about local political risks — and
how to spot them early on.

Developing economies have had a rough ride since the Federal Reserve
first mooted a wind-down of its money printing last year. The
looming withdrawal of easy cash worldwide pushed the dollar and
Treasury yields up and drove Western investors home, jarring
countries most dependent on foreign capital.

Emerging market bonds posted only their third year in the red since
1998 last year, while emerging equities ended 2013 in the red for
the second year in three.

And as the global investment tide sweeps out, it may reveal a beach
strewn with political detritus.

As competition for funds hots up while their economies rapidly lose
steam, political risks have been amplified in the so-called 'Fragile
Five' of Turkey, South Africa, India, Indonesia and Brazil, the
emerging economies with the biggest overseas financing needs.

All five face elections this year, adding to brewing local concerns
over a deepening corruption probe in Turkey or the waning popularity
of South Africa's and Brazil's leaders.

South Africa and India hold parliamentary elections in 2014, while
Brazil and Turkey have presidential elections. Indonesia has both.
In fact, 12 of the major emerging markets go to the polls in some
format this year.

"2014 will be a year in which the return impact from idiosyncratic
political events in emerging markets could increase substantially,"
asset manager M&G Investments told clients this week.

"The prospect of these elections could potentially reduce the net
capital flows into these economies on a temporary basis," it added,
citing the threat of local capital flight, delayed foreign direct
investment or portfolio flows as well as increased demand for
currency and bond hedging.

Navigating the scheduled elections may be the easy bit, however.
Some of the biggest political disruptions of the past four years
were rather more sudden, such as the Arab Spring upheavals across
the Middle East and North Africa or the more recent street protests
in Ukraine.

For funds seeking to assess political risk well in advance, some
form of advance warning system or scorecard is critical.

"WILLINGNESS TO PAY"

The world's biggest asset manager Blackrock, for example, publishes
a Sovereign Risk Index every quarter that now ranks 50 countries in
terms of governments' overall creditworthiness.

The index covers areas such as external finance needs, fiscal
policies and banking stability, but also captures the essence of
pure political risk under a heading 'Willingness to Pay'.

The introduction of Ukraine and Nigeria to the list this week saw
the two countries come in at 45th and 39th respectively on overall
ratings.

Their scores for 'Willingness to Pay', however, are far below the
average of their emerging market peers. Only Venezuela has a worse
rating than Nigeria, for example.

What's more, Blackrock highlighted the growing political element in
its risk ratings, citing the recent unrest in Thailand and Ukraine
in particular, and it said it had added an additional source in
compiling its 'willingness to pay' gauge to strengthen monitoring.

All of the "Fragile Five" flashed red on this category when Blackrock last updated this index in October.

Portfolio investors, therefore, may have their radars up in order to
exit quickly, but does this work for companies with bricks and
mortar investment on the ground?

Political risks to so-called foreign direct investments go well
beyond tax hikes or payment risks and extend to outright
expropriation of assets, threats to staff or plant and inventory
damage from conflict or social unrest.

Traditionally these risks to foreign direct investment have had to
be judged by deep local knowledge, or assessed by government
insurance bodies or bespoke political risk agencies.

But a study published by the U.S.-based National Bureau of Economic
Research this week showed that early-warning political risk gauges
can be constructed from bond market prices and provide just as
valuable a guide for business overseas.

The paper, by four U.S. economists from Columbia and Duke
Universities and Universities of Washington and North Carolina,
showed political risk gauges do provide a good warning of events
defined both by claims recorded by the U.S. government's political
risk insurance arm and major adverse news events.

By and large, they argue, sovereign spreads in emerging markets
overstate pure political risks by 3.1 percentage points.

But — in a warning as much to national policymakers as investors — their striking conclusion is that a 1 percentage point rise in the
political risk spread leads to a drop in FDI of almost 12 percent,
or some $305 million on average, for the 30 emerging countries in
major debt indices.